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* IN THE HIGH COURT OF DELHI AT NEW DELHI
10.
+ ITA 102/2015
RAMPGREEN SOLUTIONS PVT LTD ..... Appellant
Through: Mr Ajay Vohra, Sr. Advocate with
Mr Aditya Vohra, Advocate.
versus
COMMISSIONER OF INCOME TAX ..... Respondent
Through: Ms Suruchi Aggarwal, Sr. Standing
Counsel with Ms Lakshmi, Jr. Standing Counsel.
CORAM:
HON'BLE DR. JUSTICE S.MURALIDHAR
HON'BLE MR. JUSTICE VIBHU BAKHRU
ORDER
% 10.08.2015
VIBHU BAKHRU, J.
1. The Assessee has filed the present appeal under Section 260A of the
Income Tax Act, 1961 (hereafter `the Act') impugning the order dated 22 nd
March, 2013 passed by the Income Tax Appellate Tribunal (hereafter
`Tribunal') in ITA No. 6286/Del/2012. The Assessee had preferred the
aforesaid appeal before the Tribunal, impugning the assessment order passed
by the Assessing Officer (hereafter `AO') making the Transfer Pricing
Adjustments (hereafter `TP Adjustments') in respect of the As sessment Year
(hereafter `AY') 2008-09 as finalised by the Transfer Pricing Officer
ITA 102/2015 Page 1 of 42
(hereafter `TPO') pursuant to the directions issued by the Dispute
Resolution Panel (hereafter `DRP').
2. The Assessee is, essentially, aggrieved by the TP Adjustments made
in respect of the consideration for the services rendered by the Assessee to
its overseas holding company. The TP Adjustments have been made on the
basis of the average operating profit margin (operating profit as a percentage
of operating costs) declared by other companies ­ eight in number ­ selected
as comparables for the purposes of ascertaining the Arm's Length Price
(hereafter `ALP'). According to the Assessee, two of the companies chosen
as comparable by the concerned authority, namely, Vishal Information
Technology Ltd. (hereafter `Vishal') and eClerx Services Ltd. (hereafter
`eClerx') could not be considered as comparables as the functions performed
and the services rendered by the said companies were materially different
from those performed by the Assessee.
3. This Court, by an order dated 27th February, 2015, admitted the
present appeal and framed the following questions of law:-
"1. Did the ITAT fall into error in the given circumstances of
the case in confirming the transfer pricing adjustment to
the extent of Rs.5,92,07,428/- upholding the inclusion of
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two comparable, i.e., e-Clerx Services Limited and
Vishal Information Technologies Limited, now called as
Coral Hub Ltd.?
2. Did the ITAT fall into error in not appreciating the terms
of Rule l0B (2) of the Rules in respect of the analysis of
functionally comparable companies?
4. The factual context in which the aforesaid questions of law arise are
briefly stated as under:-
4.1 The Assessee is a wholly owned subsidiary of vCustomer, USA, (an
Associated Enterprise - hereafter `AE'). The Assessee is engaged in
providing voice-based customer care to the AE's clients. The Assessee
renders Call Center services, which fall within the broad description of
Information Technology Enables Services (hereafter `ITeS'). The Assessee
has two units registered under the Software Technology Park Scheme of the
Government of India, which are located at New Delhi and Pune. The
Assessee is remunerated for the voice call services on cost plus basis. The
Assessee explained that the AE undertakes all activities such as marketing
and enters into contracts with its customers seeking voice call services. The
AE bears all the business risks and the Assessee only acts as an offshore
service provider to the customers of the AE. In consideration for the
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services, the AE remunerates the Assessee by payment of all costs incurred
by the Assessee plus a mark up of fifteen percent of the costs.
4.2 During the previous year, relevant to the AY 2008-09, the Assessee
received an amount of Rs. 91,73,94,525/- for voice-based call center
services. The Assessee sought to justify the consideration received for the
international transactions entered into with the AE to be at ALP. The
Assessee submitted a Transfer Pricing Report adopting operating profit
margin as the Profit Level Indicator (hereafter `PLI') for the transfer pricing
studies. The Assessee applied the Transactional Net Margin Method
(hereafter `TNMM'), which was considered to be the most appropriate
method for the purposes of benchmarking the international transaction. The
Assessee's operating profit margin (i.e. operating profit/total cost) was
computed at 14.83% and the Assessee claimed that the same was
comparable with other companies rendering voice call services. For the
purposes of the transfer pricing study, the Assessee chose eight comparable
entities and the arithmetic average of the operating profit margins of the said
comparables was computed 15.74%. According to the Assessee, its PLI was
within the acceptable range as indicated under the second proviso to Section
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92C. The Assessee further claimed that the PLI was liable to be adjusted on
account of (i) working capital provided to the Assessee by the AE and (ii)
the risks of the business borne by the AE.
5. The AO referred the matter to the TPO. The TPO, by an order dated
19th October, 2011, passed under section 92CA(3) of the Act, computed the
TP Adjustment at Rs. 11,00,35,400/- (Rupees Eleven Crore Thirty Five
Thousand and Four Hundred). The TPO accepted the method adopted by the
Assessee (i.e. TNMM), but rejected the benchmarking report. The TPO also
rejected the Assessee's claim for any adjustment on account of working
capital provided to the Assessee and/or risks borne by the AE. The TPO
proceeded to identify a different set of comparable companies for the
purposes of determining the ALP. The companies selected by the TPO
which were considered to be comparables included eClerx and Vishal
(subsequently known as Coral Hub Ltd.). The TPO computed the average
operating profit margin of the comparable companies at 28.96% on the basis
of the average operating profit margin of eleven companies selected by the
TPO as comparables for the purposes of benchmarking the international
transactions. On the aforesaid basis, the TPO computed the TP Adjustment
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at Rs. 11,00,35,400/-. The AO incorporated the aforesaid adjustment in the
draft assessment order passed under Section 144C(1) of the Act on 20th
December, 2011. The Assessee objected to the draft assessment order dated
20th December, 2011 before the DRP. The Assessee impugned the draft
assessment order on several grounds including selection of certain
companies as comparables and exclusion of other companies considered as
appropriate comparables by the Assessee.
6. The DRP accepted the Assessee's contention with respect to certain
companies, which were considered as comparables by the TPO and directed
that the said companies be excluded for the purposes of determining the (i.e.
average operating profit margin). However, the Assessee's contentions with
regard to the exclusion of Vishal and eClerx were rejected by the DRP. The
DRP held that these companies were also providing Information Technology
Enabled Services (ITeS) and, thus, could be used as comparables. Insofar as
eClerx is concerned, the DRP held that although there were functional
dissimilarities, the same were not significant enough to warrant a rejection
of the said company as a comparable. With respect to Vishal, the DRP held
that the difference in business model of Vishal would not materially affect
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the profit margin and thus, there was no infirmity with the TPO's decision to
include the said company as a comparable in its report.
7. The TPO recomputed the TP Adjustment in terms of the directions
issued by the DRP and computed the TP Adjustment at Rs. 5,92,07,428/-.
The AO also made certain additions on account of excess deduction claimed
under Section 10A of the Act and disallowance under Section 14A of the
Act.
8. The Assessee appealed against the final assessment order dated 9 th
October, 2012, inter alia, on the ground that eClerx and Vishal could not be
considered as comparable entities for the purpose of calculating the
benchmark operating profit margin. The Assessee claimed that the said
companies were engaged in the business of Knowledge Process Outsourcing
(hereafter `KPO') and, thus, could not be included as comparables for the
purposes of benchmarking studies. According to the Assessee, although
KPO services were ITeS but the nature of the said services was materially
different from the services rendered by the Assessee. It was asserted that
eClerx is engaged in financial services in the nature of account
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reconciliation, trade order management services and has been rated as a
leading KPO by Nelso Hall. It was contended that similarly Vishal was
engaged in the services of data analytics and providing data processing
solutions to some of the largest brands in the world. Vishal too had been
rated as a leading KPO by Nelso Hall. In addition, it was pointed out that
whilst the employee costs incurred by Vishal was relatively low and
constituted only 4.39% of its total cost during the relevant year, the hire
charges, vendor payments constituted almost 87% of the total costs.
According to the Assessee, this evidenced that Vishal's business model was
different and Vishal had outsourced significant part of its operations.
9. The Tribunal rejected the Assessee's contention and held that both
eClerx and Vishal were engaged in providing ITeS and once a service fell
within that category then no sub-classification of the segment was
permissible. The Tribunal held that KPO is a term given to the branch of
BPO Services where apart from processing of data, knowledge is also
applied. The Assessee's objection that the said two companies had
abnormally high profits and thus ought to be excluded as comparables was
also rejected.
ITA 102/2015 Page 8 of 42
10. The learned counsel for the Assessee submitted that eClerx and Vishal
were KPO service providers and could not be considered as comparables for
the purposes of benchmarking the Assessee's international transactions with
the AE. The learned counsel referred to the decision of the Special Bench of
the Tribunal in Maersk Global Centers (India) Pvt. Ltd. v. ACIT, ITA
7466/Mum/2012, dated 7th March, 2014 and submitted that the issue of
whether Vishal and eClerx could be used as comparables was decided in
favour of the Assessee.
11. We have heard the counsel for the parties.
12. At the outset, it is necessary to bear in mind that the object and
purpose of introducing provisions relating to transfer pricing adjustment in
the Act. By virtue of Finance Act, 2001, Section 92 of the Act was
substituted by Sections 92 to 92F of the Act with effect from 1 st April, 2002.
Section 92 of the Act, as was in force prior to 1 st April, 2002, enabled the
AO to bring the correct profits to tax in relation to certain cross-border
transactions. However, with a large number of multi-national companies
establishing operations in India, either through their subsidiaries or through
other related ventures, a need was felt to provide a statutory framework to
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ensure that there is no avoidance of tax by transfer of income from India to
other tax jurisdictions. Circular no. 14 of 2001 issued by the CBDT indicates
that the provisions of Section 92 to 92F of the Act were introduced "With a
view to provide a detailed statutory framework which can lead to
computation of reasonable, fair and equitable profits and tax in India".
13. The heading of Chapter X also clearly indicates that it contains
"special provisions relating to avoidance of tax". The object of Chapter X
of the Act is not to tax any notional income but to ensure that the real
income is brought to tax under the Act. This has also been explained by a
Division Bench of this Court in Sony Ericsson Mobile Communications
India Pvt. Ltd. and Ors. v. Commissioner of Income Tax-III and Ors. 374
ITR 118 in the following words:-
"77. As a concept and principle Chapter X does not
artificially broaden, expand or deviate from the concept of
"real income". "Real income", as held by the Supreme Court
in Poona Electricity Supply Company Limited versus CIT, :
[1965] 57 ITR 521 (SC), means profits arrived at on
commercial principles, subject to the provisions of the Act.
Profits and gains should be true and correct profits and gains,
neither under nor over stated. Arm's length price seeks to
correct distortion and shifting of profits to tax the actual
income earned by a resident/domestic AE. The profit which
would have accrued had arm's length conditions prevailed is
brought to tax. Misreporting, if any, on account of non-arm's
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length conditions resulting in lower profits, is corrected."
14. The substratal rationale of the transfer pricing regulations is to ensure
that the true income of an Assessee is brought to tax under the Act and there
is no avoidance of tax by transfer of income from India to any other tax
jurisdiction by virtue of the influence exercised by the associated
enterprises. The aim of the provisions of Chapter X of the Act is to compute
the income in relation to a controlled transaction between an Assessee and
its associated enterprise having regard to ALP, in order to nullify the effect
of transfer of income to a jurisdiction outside India, if any, in respect of the
controlled transactions.
15. The exercise of determining the ALP in respect of international
transactions between the related enterprises is aimed to determine the price,
which would have been charged for products and services, as nearly as
possible, in case such international transactions were not controlled by virtue
of them being executed between related parties. The object of the exercise
is, thus, to remove the effect of any influence on the prices or costs that may
have been exerted on account of the international transactions being entered
into between related parties. It is, at once, clear that for the exercise of
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determining ALP to be reliable, it is necessary that the controlled
transactions be compared with uncontrolled transactions which are similar in
all material aspects.
16. We may now refer to the relevant provisions of Chapter X of the Act
keeping in view the aforesaid purpose and object of introducing the said
provisions in the Act.
17. Section 92 of the Act provides that the income arising from an
international transaction would be computed having regard to the ALP. The
said section further provides for cost and expenses to be allocated and
apportioned between two or more associated enterprises with regard to ALP.
18. Section 92C of the Act provides for provisions relating to
computation of ALP. Sub-section (1) of Section 92C of the Act provides for
the methods of computing the ALP and sub-section (2) of Section 92C of the
Act mandates that the most appropriate method that has been referred to in
Section 92C(1) be applied for determination of ALP. Sub-section (1) and
(2) of Section 92(C) of the Act reads as under:-
ITA 102/2015 Page 12 of 42
"92C. (1) The arm's length price in relation to an international
transaction or specified domestic transaction shall be
determined by any of the following methods, being the most
appropriate method, having regard to the nature of transaction
or class of transaction or class of associated persons or
functions performed by such persons or such other relevant
factors as the Board may prescribe, namely :--
(a) comparable uncontrolled price method;
(b) resale price method;
(c) cost plus method;
(d) profit split method;
(e) transactional net margin method;
(f) such other method as may be prescribed by the Board.
(2) The most appropriate method referred to in sub-section (1)
shall be applied, for determination of arm's length price, in the
manner as may be prescribed:
Provided that where more than one price is determined by the
most appropriate method, the arm's length price shall be taken
to be the arithmetical mean of such prices:
Provided further that if the variation between the arm's length
price so determined and price at which the international
transaction or specified domestic transaction has actually been
undertaken does not exceed such percentage not exceeding
three per cent of the latter, as may be notified by the Central
Government in the Official Gazette in this behalf, the price at
which the international transaction or specified domestic
transaction has actually been undertaken shall be deemed to be
the arm's length price :
Provided also that where more than one price is determined by
the most appropriate method, the arm's length price in relation
to an international transaction or specified domestic
ITA 102/2015 Page 13 of 42
transaction undertaken on or after the 1st day of April, 2014,
shall be computed in such manner as may be prescribed and
accordingly the first and second proviso shall not apply.
Explanation.--For the removal of doubts, it is hereby clarified
that the provisions of the second proviso shall also be
applicable to all assessment or reassessment proceedings
pending before an Assessing Officer as on the 1st day of
October, 2009."
19. It is also necessary to refer to Rule 10B of the Income Tax Rules,
1962 which provides for determination of ALP under Section 92C of the
Act. Sub-rule(1) of Rule 10B contains provisions in relation to various
methods of calculation of ALP as provided under Section 92C of the Act
and reads as under:-
"10B. (1) For the purposes of sub-section (2) of section 92C,
the arm's length price in relation to an international
transaction or a specified domestic transaction shall be
determined by any of the following methods, being the most
appropriate method, in the following manner, namely :--
(a) comparable uncontrolled price method, by which,--
(i) the price charged or paid for property transferred or
services provided in a comparable uncontrolled
transaction, or a number of such transactions, is
identified;
(ii) such price is adjusted to account for differences, if
any, between the international transaction or the
specified domestic transaction and the comparable
uncontrolled transactions or between the enterprises
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entering into such transactions, which could
materially affect the price in the open market;
(iii) the adjusted price arrived at under sub-clause (ii) is
taken to be an arm's length price in respect of the
property transferred or services provided in the
international transaction or the specified domestic
transaction;
(b) resale price method, by which,--
(i) the price at which property purchased or services
obtained by the enterprise from an associated
enterprise is resold or are provided to an unrelated
enterprise, is identified;
(ii) such resale price is reduced by the amount of a
normal gross profit margin accruing to the enterprise
or to an unrelated enterprise from the purchase and
resale of the same or similar property or from
obtaining and providing the same or similar services,
in a comparable uncontrolled transaction, or a number
of such transactions;
(iii) the price so arrived at is further reduced by the
expenses incurred by the enterprise in connection
with the purchase of property or obtaining of
services;
(iv) the price so arrived at is adjusted to take into account
the functional and other differences, including
differences in accounting practices, if any, between
the international transaction or the specified domestic
transaction and the comparable uncontrolled
transactions, or between the enterprises entering into
such transactions, which could materially affect the
amount of gross profit margin in the open market;
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(v) the adjusted price arrived at under sub-clause (iv) is
taken to be an arm's length price in respect of the
purchase of the property or obtaining of the services
by the enterprise from the associated enterprise;
(c) cost plus method, by which,--
(i) the direct and indirect costs of production incurred by
the enterprise in respect of property transferred or
services provided to an associated enterprise, are
determined;
(ii) the amount of a normal gross profit mark-up to such
costs (computed according to the same accounting
norms) arising from the transfer or provision of the
same or similar property or services by the enterprise,
or by an unrelated enterprise, in a comparable
uncontrolled transaction, or a number of such
transactions, is determined;
(iii) the normal gross profit mark-up referred to in sub-
clause (ii) is adjusted to take into account the
functional and other differences, if any, between the
international transaction or the specified domestic
transaction and the comparable uncontrolled
transactions, or between the enterprises entering into
such transactions, which could materially affect such
profit mark-up in the open market;
(iv) the costs referred to in sub-clause (i) are increased by
the adjusted profit mark-up arrived at under sub-
clause (iii);
(v) the sum so arrived at is taken to be an arm's length
price in relation to the supply of the property or
provision of services by the enterprise;
(d) profit split method, which may be applicable mainly in
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international transactions or specified domestic
transactions involving transfer of unique intangibles or in
multiple international transactions or specified domestic
transactions which are so interrelated that they cannot be
evaluated separately for the purpose of determining the arm's
length price of any one transaction, by which--
(i) the combined net profit of the associated
enterprises arising from the international
transaction or the specified domestic transaction in
which they are engaged, is determined;
(ii) the relative contribution made by each of the
associated enterprises to the earning of such
combined net profit, is then evaluated on the basis
of the functions performed, assets employed or to
be employed and risks assumed by each enterprise
and on the basis of reliable external market data
which indicates how such contribution would be
evaluated by unrelated enterprises performing
comparable functions in similar circumstances;
(iii) the combined net profit is then split amongst the
enterprises in proportion to their relative
contributions, as evaluated under sub-clause (ii);
(iv) the profit thus apportioned to the assessee is taken
into account to arrive at an arm's length price in
relation to the international transaction or the
specified domestic transaction:
Provided that the combined net profit referred to in sub-clause
(i) may, in the first instance, be partially allocated to each
enterprise so as to provide it with a basic return appropriate for
the type of international transaction or specified domestic
transaction in which it is engaged, with reference to market
returns achieved for similar types of transactions by
independent enterprises, and thereafter, the residual net profit
remaining after such allocation may be split amongst the
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enterprises in proportion to their relative contribution in the
manner specified under sub-clauses (ii) and (iii), and in such a
case the aggregate of the net profit allocated to the enterprise
in the first instance together with the residual net profit
apportioned to that enterprise on the basis of its relative
contribution shall be taken to be the net profit arising to that
enterprise from the international transaction or the specified
domestic transaction ;
(e) transactional net margin method, by which,--
(i) the net profit margin realised by the enterprise
from an international transaction or a specified
domestic transaction entered into with an
associated enterprise is computed in relation to
costs incurred or sales effected or assets employed
or to be employed by the enterprise or having
regard to any other relevant base;
(ii) the net profit margin realised by the enterprise or
by an unrelated enterprise from a comparable
uncontrolled transaction or a number of such
transactions is computed having regard to the
same base;
(iii) the net profit margin referred to in sub-clause (ii)
arising in comparable uncontrolled transactions is
adjusted to take into account the differences, if
any, between the international transaction or the
specified domestic transaction and the comparable
uncontrolled transactions, or between the
enterprises entering into such transactions, which
could materially affect the amount of net profit
margin in the open market;
(iv) the net profit margin realised by the enterprise and
referred to in sub-clause (i) is established to be the
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same as the net profit margin referred to in sub-
clause (iii);
(v) the net profit margin thus established is then taken
into account to arrive at an arm's length price in
relation to the international transaction or the
specified domestic transaction;
(f) any other method as provided in rule 10AB."
For the purposes of the present case, clause (e) of sub-rule (1) of Rule 10B is
relevant as it pertains to determination of ALP by TNMM.
20. In order for the benchmarking studies to be reliable for the purposes
of determining the ALP, it would be essential that the entities selected as
comparables are functionally similar and are subject to the similar business
environment and risks as the tested party. In order to impute an ALP to a
controlled transaction, it would be essential to ensure that the instances of
uncontrolled entities/transactions selected as comparables are similar in all
material aspects that have any bearing on the value or the profitability, as the
case may be, of the transaction. Any factor, which has an influence on the
PLI, would be material and it would be necessary to ensure that the
comparables are also equally subjected to the influence of such factors as the
tested party. This would, obviously, include business environment; the
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nature and functions performed by the tested party and the comparable
entities; the value addition in respect of products and services provided by
parties; the business model; and the assets and resources employed. It cannot
be disputed that the functions performed by an entity would have a material
bearing on the value and profitability of the entity. It is, therefore, obvious
that the comparables selected and the tested party must be functionally
similar for ascertaining a reliable ALP by TNMM. Rule 10B(2) of the
Income Tax Rules, 1962 also clearly indicates that the comparability of
controlled transactions would be judged with reference to the factors as
indicated therein. Clause (a) and (b) of Rule 10B(2) expressly indicate that
the specific characteristics of the services provided and the functions
performed would be factors for considering the comparability of
uncontrolled transactions with controlled transactions.
21. Rule 10B(2) reads as under:-
"(2) For the purposes of sub-rule (1), the comparability of an
international transaction or a specified domestic transaction
with an uncontrolled transaction shall be judged with reference
to the following, namely:--
(a) the specific characteristics of the property transferred
or services provided in either transaction;
(b) the functions performed, taking into account assets
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employed or to be employed and the risks assumed,
by the respective parties to the transactions;
(c) the contractual terms (whether or not such terms are
formal or in writing) of the transactions which lay
down explicitly or implicitly how the responsibilities,
risks and benefits are to be divided between the
respective parties to the transactions;
(d) conditions prevailing in the markets in which the
respective parties to the transactions operate,
including the geographical location and size of the
markets, the laws and Government orders in force,
costs of labour and capital in the markets, overall
economic development and level of competition and
whether the markets are wholesale or retail."
22. In the facts of the present case, it is not disputed that Vishal and
eClerx are entities engaged in Knowledge Process Outsourcing Services
(KPO Services). Thus, the principal question to be addressed is whether a
KPO Service provider could be considered as a comparable for
benchmarking international transactions entered into by an entity rendering
voice call services ­ such as the Assessee ­with its associated enterprise by
using TNMM and taking operating profit margin as the PLI .
23. In this case, the Tribunal noted that eClerx was engaged in data
processing and analytics services and held that the activities of the Assessee
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were functionally similar to those of eClerx. The Tribunal concluded that
voice call services and KPO services were essentially ITeS and, therefore,
entities rendering the aforesaid services could be considered as comparables
for the purpose of benchmarking international transactions by using TNMM.
The Tribunal held that further sub-division of ITeS was not permissible. The
Tribunal followed its earlier decision in Willis Processing Services (I) (P.)
Ltd. v. Dy. CIT 30 ITR (Trib)129 (Mumbai) 2014.
24. It is not disputed that voice call services are considered to be the
lower-end of ITeS. KPO on the other hand are ITeS where the service
providers have to employ advanced level of skills and knowledge.
Notification No. SO2810(E) dated 18th September 2013 issued by the
CBDT notifying Safe Harbour Rules also indicates the above. Rule 10TA(g)
of the said Rules defines KPO Services as under:-
" (g) "knowledge process outsourcing services" means
the following business process outsourcing services
provided mainly with the assistance or use of
information technology requiring application of
knowledge and advanced analytical and technical skills,
namely:
(i) geographic information system;
(ii) human resources services;
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(iii) engineering and design services;
(iv) animation or content development and
management;
(v) business analytics;
(vi) financial analytics; or
(vii) market research,
but does not include any research and development
services whether or not in the nature of contract
research and development services;"
25. Whilst Voice Call Center represents the lower-end of ITeS, KPO
represents services involving a higher level of skills and knowledge. India
has vast human resources and a large number of highly-skilled technical
professionals. The expression "KPO" indicates the involvement of domain
knowledge in providing ITeS. Typically, KPO includes involvement of
advance skills; the services provided may include analytical services, market
research, legal research, engineering and design services, intellectual
management etc. On the other hand, Voice Call Centers are normally
involved in customer support and processing of routine data. In the case of
Maersk Global Centers (India) Pvt. Ltd. v. ACIT (supra) a Special Bench
of the Tribunal had referred to a report prepared by National Skill
Development Corporation (NSDC) on Human Resource and Skill
Requirements in IT and ITES Sector (2022) and noted that the KPO sector
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has been described as "a value play". The said report also indicates that
KPO services are likely to span activities such as "patent advisory, high -end
research and analytics, online market research and legal advisory".
26. A Knowledge Process is understood as a high value added process
chain wherein the processes are dependent on advanced skills, domain
knowledge and the experience of the persons carrying on such processes.
27. The Government of Rajasthan (Department of Information
Technology & Communication) has also floated a scheme on 12 th December,
2011 known as "The Rajasthan Incentive Scheme for BPO Centers and KPO
Centers, 2011". The said scheme is for providing incentives to promote ITeS
and to generate further employment opportunities. In terms of the said
scheme, "Business Process Outsourcing (BPO)" is defined to mean "the
transfer of an organization's entire non-core but critical business
process/function to an external centre which uses an IT-based service
delivery" and "Knowledge Processing Outsourcing (KPO)" has been
defined to mean "allocation of relatively high-level tasks to an outside
organization or a different group (possibly in a different location) within the
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same organization. KPO is, essentially, high-end Business Process
Outsourcing (BPO)".
28. In our view, the definition of KPO provided under the afore-
mentioned scheme also indicates that KPO services are understood as the
higher-end of ITeS in terms of value addition.
29. It is apparent from the above that while entities rendering Voice Call
Center services for customer support and a KPO service provider may be
employing IT-based delivery systems, the characteristics of services, the
functional aspects, business environment, risks and the quality of human
resource employed would be materially different. It plainly follows that
benchmarking international transactions on the basis of comparing the PLI
of high-end KPO service providers with the PLI of Voice Call Centers
would be unreliable and possibly flawed.
30. As indicated above, in order to determine the ALP in relation to a
controlled transaction, the analysis must include comparables which are
similar in all aspects that have a material bearing on their profitability.
ITA 102/2015 Page 25 of 42
Paragraph 1.36 of the "OECD Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations" published in 2010 (hereafter `OECD
Guidelines') indicates the "comparability factors" which are important while
considering the comparability of uncontrolled transactions/entities with the
controlled transactions/entities. Sub-rule (2) of rule 10B of the Income Tax
Rules, 1962 also mandates that the comparability of international
transactions with uncontrolled transactions would be judged with reference
to the factors indicated under clauses (a) to (d) of that sub-rule, which are
similar to the comparability factors as indicated under the OECD
Guidelines. These include characteristics of property or services transferred
and functions performed. The relevant extract from the OECD Guidelines
are quoted below:
"1.36 As noted above, in making these comparisons,
material differences between the compared transactions
or enterprises should be taken into account. In order to
establish the degree of actual comparability and then to
make appropriate adjustments to establish arm's length
conditions (or a range thereof), it is necessary to compare
attributes of the transactions or enterprises that would
affect conditions in arm's length transactions. Attributes
or "comparability factors" that may be important when
determining comparability include the characteristics of
the property or services transferred, the functions
performed by the parties (taking into account assets used
and risks assumed), the contractual terms, the economic
circumstances of the parties, and the business strategies
ITA 102/2015 Page 26 of 42
pursued by the parties. These comparability factors are
discussed in more detail at Section D.1.2 below.
xxxx xxxx xxxx xxxx
1.39 Differences in the specific characteristics of property
or services often account, at least in part, for differences
in their value in the open market. Therefore, comparisons
of these features may be useful in determining the
comparability of controlled and uncontrolled transactions.
Characteristics that may be important to consider include
the following: in the case of transfers of tangible
property, the physical features of the property, its quality
and reliability, and the availability and volume of supply;
in the case of the provision of services, the nature and
extent of the services; and in the case of intangible
property, the form of transaction (e.g. licensing or sale),
the type of property (e.g. patent, trademark, or know-
how), the duration and degree of protection, and the
anticipated benefits from the use of the property.
1.40 Depending on the transfer pricing method, this factor
must be given more or less weight. Among the methods
described at Chapter II of these Guidelines, the
requirement for comparability of property or services is
the strictest for the comparable uncontrolled price
method. Under the comparable uncontrolled price
method, any material difference in the characteristics of
property or services can have an effect on the price and
would require an appropriate adjustment to be considered
(see in particular paragraph 2.15). Under the resale price
method and cost plus method, some differences in the
characteristics of property or services are less likely to
have a material effect on the gross profit margin or mark-
up on costs (see in particular paragraphs 2.23 and 2.41).
Differences in the characteristics of property or services
are also less sensitive in the case of the transactional
profit methods than in the case of traditional transaction
methods (see in particular paragraph 2.69). This however
ITA 102/2015 Page 27 of 42
does not mean that the question of comparability in
characteristics of property or services can be ignored
when applying these methods, because it may be that
product differences entail or reflect different functions
performed, assets used and/or risks assumed by the tested
party. See paragraphs 3.18-3.19 for a discussion of the
notion of tested party.
1.41 In practice, it has been observed that comparability
analyses for methods based on gross or net profit
indicators often put more emphasis on functional
similarities than on product similarities. Depending on the
facts and circumstances of the case, it may be acceptable
to broaden the scope of the comparability analysis to
include uncontrolled transactions involving products that
are different, but where similar functions are undertaken.
However, the acceptance of such an approach depends on
the effects that the product differences have on the
reliability of the comparison and on whether or not more
reliable data are available. Before broadening the search
to include a larger number of potentially comparable
uncontrolled transactions based on similar functions
being undertaken, thought should be given to whether
such transactions are likely to offer reliable comparables
for the controlled transaction.
D.1.2.2 Functional analysis
1.42 In transactions between two independent enterprises,
compensation usually will reflect the functions that each
enterprise performs (taking into account assets used and
risks assumed). Therefore, in determining whether
controlled and uncontrolled transactions or entities are
comparable, a functional analysis is necessary. This
functional analysis seeks to identify and compare the
economically significant activities and responsibilities
undertaken, assets used and risks assumed by the parties
to the transactions. For this purpose, it may be helpful to
understand the structure and organisation of the group
and how they influence the context in which the taxpayer
ITA 102/2015 Page 28 of 42
operates. It will also be relevant to determine the legal
rights and obligations of the taxpayer in performing its
functions.
1.43 The functions that taxpayers and tax administrations
might need to identify and compare include, e.g. design,
manufacturing, assembling, research and development,
servicing, purchasing, distribution, marketing,
advertising, transportation, financing and management.
The principal functions performed by the party under
examination should be identified. Adjustments should be
made for any material differences from the functions
undertaken by any independent enterprises with which
that party is being compared. While one party may
provide a large number of functions relative to that of the
other party to the transaction, it is the economic
significance of those functions in terms of their
frequency, nature, and value to the respective parties to
the transactions that is important.
1.44 The functional analysis should consider the type of
assets used, such as plant and equipment, the use of
valuable intangibles, financial assets, etc., and the nature
of the assets used, such as the age, market value, location,
property right protections available, etc.
1.45 Controlled and uncontrolled transactions and entities
are not comparable if there are significant differences in
the risks assumed for which appropriate adjustments
cannot be made. Functional analysis is incomplete unless
the material risks assumed by each party have been
considered since the assumption or allocation of risks
would influence the conditions of transactions between
the associated enterprises. Usually, in the open market,
the assumption of increased risk would also be
compensated by an increase in the expected return,
although the actual return may or may not increase
depending on the degree to which the risks are actually
realised.
ITA 102/2015 Page 29 of 42
1.46 The types of risks to consider include market risks,
such as input cost and output price fluctuations; risks of
loss associated with the investment in and use of
property, plant, and equipment; risks of the success or
failure of investment in research and development;
financial risks such as those caused by currency exchange
rate and interest rate variability; credit risks; and so forth.
xxxx xxxx xxxx xxxx
1.51 In some cases, it has been argued that the relative
lack of accuracy of the functional analysis of possible
external comparables (as defined in paragraph 3.24)
might be counterbalanced by the size of the sample of
third party data; however quantity does not make up for
poor quality of data in producing a sufficiently reliable
analysis. See paragraphs 3.2, 3.38 and 3.46. "
31. In the present case, the Tribunal noted that Vishal and eClerx were
both engaged in rendering ITeS. The Tribunal held that, "once a service
falls under the category of ITeS, then there is no sub-classification of
segment". Thus, according to the Tribunal, no differentiation could be made
between the entities rendering ITeS. We find it difficult to accept this view
as it is contrary to the fundamental rationale of determining ALP by
comparing controlled transactions/entities with similar uncontrolled
transactions/entities. ITeS encompasses a wide spectrum of services that use
Information Technology based delivery. Such services could include
rendering highly technical services by qualified technical personnel,
ITA 102/2015 Page 30 of 42
involving advanced skills and knowledge, such as engineering, design and
support. While, on the other end of the spectrum ITeS would also include
voice-based call centers that render routine customer support for their
clients. Clearly, characteristics of the service rendered would be dissimilar.
Further, both service providers cannot be considered to be functionally
similar. Their business environment would be entirely different, the demand
and supply for the services would be different, the assets and capital
employed would differ, the competence required to operate the two services
would be different. Each of the aforesaid factors would have a material
bearing on the profitability of the two entities. Treating the said entities to
be comparables only for the reason that they use Information Technology for
the delivery of their services, would, in our opinion, be erroneous.
32. It has been pointed out that whilst the Tribunal in Willis Processing
Services (India) Pvt. Ltd. v. DCIT (supra) held that no distinction could be
made between KPO and BPO service providers, however, a contrary view
had been taken by several benches of the Tribunal in other cases. In Capital
IQ Information System India (P.) Ltd. v. Dy. CIT, (IT) [2013] 32
taxmann.com 21 and Lloyds TSB Global Services Pvt. Ltd. v. DCIT, (ITA
ITA 102/2015 Page 31 of 42
No. 5928/Mum/2012 dated 21th November 2012), the Hyderabad and
Mumbai Bench of the Tribunal respectively accepted the view that a BPO
service provider could not be compared with a KPO service provider.
33. The Special Bench of the Tribunal in Maersk Global Centers (India)
Pvt. Ltd. (supra) struck a different cord. The Special Bench of the Tribunal
held that even though there appears to be a difference between BPO and
KPO Services, the line of difference is very thin. The Tribunal was of the
view that there could be a significant overlap in their activities and it may be
difficult to classify services strictly as falling under the category of either a
BPO or a KPO. The Tribunal also observed that one of the key success
factors of the BPO Industry is its ability to move up the value chain through
KPO service offering. For the aforesaid reasons, the Special Bench of the
Tribunal held that ITeS Services could not be bifurcated as BPO and KPO
Services for the purpose of comparability analysis in the first instance. The
Tribunal proceeded to hold that a relatively equal degree of comparability
can be achieved by selecting potential comparables on a broad functional
analysis at ITeS level and that the comparables so selected could be put to
further test by comparing specific functions performed in the international
ITA 102/2015 Page 32 of 42
transactions with uncontrolled transactions to attain relatively equal degree
of comparability.
34. We have reservations as to the Tribunal's aforesaid view in Maersk
Global Centers (India) Pvt. Ltd. (supra). As indicated above, the expression
`BPO' and `KPO' are, plainly, understood in the sense that whereas, BPO
does not necessarily involve advanced skills and knowledge; KPO, on the
other hand, would involve employment of advanced skills and knowledge
for providing services. Thus, the expression `KPO' in common parlance is
used to indicate an ITeS provider providing a completely different nature of
service than any other BPO service provider. A KPO service provider would
also be functionally different from other BPO service providers, inasmuch as
the responsibilities undertaken, the activities performed, the quality of
resources employed would be materially different. In the circumstances, we
are unable to agree that broadly ITeS sector can be used for selecting
comparables without making a conscious selection as to the quality and
nature of the content of services. Rule 10B(2)(a) of the Income Tax Rules,
1962 mandates that the comparability of controlled and uncontrolled
transactions be judged with reference to service/product characteristics. This
ITA 102/2015 Page 33 of 42
factor cannot be undermined by using a broad classification of ITeS which
takes within its fold various types of services with completely different
content and value. Thus, where the tested party is not a KPO service
provider, an entity rendering KPO services cannot be considered as a
comparable for the purposes of Transfer Pricing analysis. The perception
that a BPO service provider may have the ability to move up the value chain
by offering KPO services cannot be a ground for assessing the transactions
relating to services rendered by the BPO service provider by benchmarking
it with the transactions of KPO services providers. The object is to ascertain
the ALP of the service rendered and not of a service (higher in value chain)
that may possibly be rendered subsequently.
35. As pointed out by the Special Bench of the Tribunal in Maersk
Global Centers (India) Pvt. Ltd. (supra), there may be cases where an entity
may be rendering a mix of services some of which may be functionally
comparable to a KPO while other services may not. In such cases a
classification of BPO and KPO may not be feasible. Clearly, no straitjacket
formula can be applied. In cases where the categorization of services
rendered cannot be defined with certainty, it would be apposite to employ
ITA 102/2015 Page 34 of 42
the broad functionality test and then exclude uncontrolled entities, which are
found to be materially dissimilar in aspects and features that have a bearing
on the profitability of those entities. However, where the controlled
transactions are clearly in the nature of lower-end ITeS such as Call Centers
etc. for rendering data processing not involving domain knowledge,
inclusion of any KPO service provider as a comparable would not be
warranted and the transfer pricing study must take that into account at the
threshold.
36. As pointed out earlier, the transfer pricing analysis must serve the
broad object of benchmarking an international transaction for determining
an ALP. The methodology necessitates that the comparables must be similar
in material aspects. The comparability must be judged on factors such as
product/service characteristics, functions undertaken, assets used, risks
assumed. This is essential to ensure the efficacy of the exercise. There is
sufficient flexibility available within the statutory framework to ensure a fair
ALP.
37. Applying the aforesaid principles to the facts of the present case, it is
ITA 102/2015 Page 35 of 42
once again clear that both Vishal and eClerx could not be taken as
comparables for determining the ALP. Vishal and eClerx, both are into KPO
Services. In Maersk Global Centers (India) Pvt. Ltd. (supra), the Special
Bench of the Tribunal had noted that eClerx is engaged in data analytics,
data processing services, pricing analytics, bundling optimization, content
operation, sales and marketing support, product data management, revenue
management. In addition, eClerx also offered financial services such as
real-time capital markets, middle and back-office support, portfolio risk
management services and various critical data management services.
Clearly, the aforesaid services are not comparable with the services rendered
by the Assessee. Further, the functions undertaken (i.e. the activities
performed) are also not comparable with the Assessee. In our view, the
Tribunal erred in holding that the functions performed by the Assessee were
broadly similar to that of eClerx or Vishal. The operating margin of eClerx,
thus, could not be included to arrive at an ALP of controlled transactions,
which were materially different in its content and value. In Maersk Global
Centers (India) Pvt. Ltd. (supra), the Special Bench of the Tribunal had
noted the same and had, thus, excluded eClerx as a comparable. It is further
observed that the comparability of eClerx had also been examined by the
ITA 102/2015 Page 36 of 42
Hyderabad Bench of the Tribunal in M/s Capital Iq Information Systems
(India) (P.) Ltd. v. Additional Commissioner of Income-tax (supra),
wherein, the Tribunal directed the exclusion of eClerx as a comparable for
the reason that it was engaged in providing KPO Services and further that it
had also returned supernormal profits.
38. In our view, even Vishal could not be considered as a comparable, as
admittedly, its business model was completely different. Admittedly,
Vishal's expenditure on employment cost during the relevant period was a
small fraction of the proportionate cost incurred by the Assessee, apparently,
for the reason that most of its work was outsourced to other vendors/service
providers. The DRP and the Tribunal erred in brushing aside this vital
difference by observing that outsourcing was common in ITeS industry and
the same would not have a bearing on profitability. Plainly, a business
model where services are rendered by employing own employees and using
one's own infrastructure would have a different cost structure as compared
to a business model where services are outsourced. There was no material
for the Tribunal to conclude that the outsourcing of services by Vishal
would have no bearing on the profitability of the said entity.
ITA 102/2015 Page 37 of 42
39. It is also relevant to note that in the case of Maersk Global Centers
(India) Pvt. Ltd. (supra), the DRP itself had accepted the objection of the
Assessee and had excluded Vishal as a comparable for the reason as quoted
below:-
"... that it had a very low employment cost and very high
cost on account of venture payment, which suggested that its
business model was that of an outsourcing company and in
view of this functional difference, Vishal Ltd. could not be
considered as a comparable."
40. The Assessee had also sought the exclusion of eClerx and Vishal on
the ground that both the companies had returned supernormal profits.
Whereas the operating margins (operating margin over total cost) in case of
Vishal and eClerx were 50.68% and 65.88% respectively, the PLIs of all
other comparables were in the range of 2.2% to 24%. In our view, it would
not be apposite to exclude comparables only for the reason that their profits
are high, as the same is not provided for in the statutory framework. The
OECD Guidelines suggest that a quartile method be adopted which excludes
entities that fall in the extreme quartiles for comparability. However, neither
Chapter X of the Act nor the Rules made by CBDT provide for exclusion for
such statistical reason.
ITA 102/2015 Page 38 of 42
41. Having stated the same, it may be necessary to bear in mind that
supernormal profits may in certain cases indicate a functional dissimilarity
or dissimilarity with respect to a feature that has a material bearing on the
profitability. In such circumstances, it would be necessary to undertake
further analysis to eliminate the possibility of the high profits resulting on
account of any material dissimilarity between the tested party and the chosen
comparable. A wide deviation in the PLI amongst selected comparables
could be indicative that the comparables selected are either materially
dissimilar or the data used is not reliable. The Tribunal proceeded on the
basis that an adjustment could be made only in cases where supernormal
profits resulted from the factors indicated in Rule 10B of the Income Tax
Rules, 1962. In our view, the factors mentioned in Rule 10B are not
exhaustive. The principal object of benchmarking international transactions
against uncontrolled transactions is to impute an ALP to those transactions.
This exercise would fail if a factor, which has a material bearing on the
value or the profitability, as the case may be, depending on the method used,
is ignored.
42. Before concluding, there is yet another aspect of the matter that needs
ITA 102/2015 Page 39 of 42
consideration. The Tribunal proceeded on the basis that while applying
TNMM method, broad functionality is sufficient and it is not necessary that
further effort be taken to find a comparable entity rendering services of
similar characteristics as the tested entity. The DRP held that TNMM
allows flexibility and tolerance in selection of comparables, as functional
dissimilarities are subsumed at net margin levels, as compared to Resale
Price Method or Comparable Uncontrolled Price Method and, therefore, the
functional dissimilarities pointed out by the Assessee did not warrant
rejection of eClerx and Vishal as comparables.
43. In our view, the aforesaid approach would not be apposite. Insofar as
identifying comparable transactions/entities is concerned, the same would
not differ irrespective of the transfer pricing method adopted. In other
words, the comparable transactions/entities must be selected on the basis of
similarity with the controlled transaction/entity. Comparability of controlled
and uncontrolled transactions has to be judged, inter alia, with reference to
comparability factors as indicated under rule 10B(2) of the Income Tax
Rules, 1962. Comparability analysis by TNMM method may be less
sensitive to certain dissimilarities between the tested party and the
ITA 102/2015 Page 40 of 42
comparables. However, that cannot be the consideration for diluting the
standards of selecting comparable transactions/entities. A higher product
and functional similarity would strengthen the efficacy of the method in
ascertaining a reliable ALP. Therefore, as far as possible, the comparables
must be selected keeping in view the comparability factors as specified.
Wide deviations in PLI must trigger further investigations/analysis.
44. Consideration for a transaction would reflect the functions performed,
the significant activities undertaken, the assets or resources used/consumed,
the risks assumed. Thus, comparison of activities undertaken/functions
performed is important for determining the comparability between
controlled and uncontrolled transactions/entity. It would not be apposite to
ignore functional dissimilarity only for the reason that its impact may be
reduced on account of using arithmetical mean of the PLI. The DRP had
noted that eClerx was functionally dissimilar, but ignored the same relying
on an assumption that the functional dissimilarity would be subsumed in the
profit margin. As noted, the content of services provided by the Assessee
and the entities in question were not similar. In addition, there were also
functional dissimilarities between the Assessee and the two entities in
question. In our view, these comparability factors could not be ignored by
ITA 102/2015 Page 41 of 42
the Tribunal. While using TNMM, the search for comparables may be
broadened by including comparables offering services/products which are
not entirely similar to the controlled transaction/entity. However, this can be
done only if (a) the functions performed by the tested party and the selected
comparable entity are similar including the assets used and the risks
assumed; and (b) the difference in services/products offered has no material
bearing on the profitability.
45. In view of the aforesaid, the questions of law framed by an order
dated 27th February, 2015 are answered in the affirmative and against the
Revenue. The impugned order dated 22nd March, 2013 of the Tribunal and
the final assessment order dated 9th October, 2012 are hereby set aside. The
appeal is allowed.
VIBHU BAKHRU, J
S. MURALIDHAR, J
AUGUST 10, 2015
RK
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